ESTATE PLANNING: WHAT NEXT? - The Blum Firmtheblumfirm.com/pdf/MEB Tax Institute Speech FINAL.pdf · 2011-05-12 · by requiring consistent valuations for tra nsfer tax and income

Marvin E. Blum*•Gary V. Post*John R. Hunter"•Daniel H. McCarthy"•Steven W. Novak*Len Woodard•Catherine R. Moon*•Amanda L. Holliday*•Laurel Stephenson*Laura L. Bower-Haley*Amy E. Ott•Rachel W. SaltsmanKent H. McMahan,* Senior Counsel

The Blum Firm, P.C.Attorneys at Law

Fort Worth | Dallas

777 Main Street, Suite 700Fort Worth, Texas 76102

(817) 334-0066(817) 334-0078 (fax)

200 Crescent Court, Suite 520Dallas, Texas 75201

(214) 751-2130(214) 751-2160 (fax)

[email protected]

Board Certified by the Texas Board of Legal Specialization*Estate Planning & Probate Law "Tax Law

•Certified Public Accountant

ESTATE PLANNING: WHAT NEXT?

Fort Worth ChapterTexas Society of Certified Public Accountants

Tax InstituteAugust 5, 2010

by Marvin E. Blum

© 2010, The Blum Firm, P.C.

MARVIN BLUMBIOGRAPHICAL INFORMATION

MARVIN BLUM, founding partner of THE BLUM FIRM, P.C. with law offices in Fort

Worth and Dallas, specializes in the areas of estate planning and probate, asset protection planning,

planning for closely-held businesses, tax planning, tax controversy, and charitable planning.

Blum, an attorney and certified public accountant, is Board Certified in Estate Planning and

Probate Law and is a Fellow of the American College of Trust and Estate Counsel. He received his

undergraduate degree in accounting at The University of Texas at Austin where he graduated first

in his class and was named Ernst & Ernst Outstanding Student in Accounting. Blum received his

law degree from The University of Texas School of Law where he graduated second in his class and

was named the Prentice-Hall Outstanding Student in Taxation.

Blum is a frequent speaker and author on estate planning and tax topics. Since 2003, he has

been included on Texas Monthly’s annual list of Texas Super Lawyers, a list consisting of only five

percent of all attorneys in the state. Additionally, Blum has been included in Texas Monthly’s “Top

100 Super Lawyers” for the State of Texas. Recently, Blum received national recognition by New

York’s Worth magazine by being named to its prestigious “Nation’s Top 100 Attorneys” list,

comprising nominations from throughout the United States.

Blum is active in the Fort Worth community, serving in his 31 year as Treasurer of the Fortst

Worth Symphony. He is a lifetime trustee of Trinity Valley School where he served five years as

President of the Board. Blum also served as chairman of The Multicultural Alliance, an organization

devoted to fighting bias, bigotry, and racism. He and his wife, Laurie, are the parents of Adam, also

a CPA and employed by Austin Ventures in Austin, Texas, and Elizabeth, currently residing in

Philadelphia working on her Masters Degree at the University of Pennsylvania.

ESTATE PLANNING: WHAT’S NEXT?

TABLE OF CONTENTS

Page #

I. 2010 COMPLIANCE: STATUS OF ESTATE PLANNING LEGISLATION. . . . . . . . . . 2

A. SUMMARY OF ESTATE AND GIFT TAX LAWS DURING 2010.. . . . . . . . . . 3

B. REVIEWING AND DRAFTING ESTATE PLANNING DOCUMENTS IN 2010. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

C. GENERATION-SKIPPING TRANSFER TAX ISSUES IN 2010. . . . . . . . . . . . . 4

D. SUNSET PROVISIONS AFFECTING 2010 LAWS. . . . . . . . . . . . . . . . . . . . . . . 5

II. FAMILY LIMITED PARTNERSHIPS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

A. INDIRECT GIFT ARGUMENTS FOR FLP AND LLC INTERESTS.. . . . . . . . . 6

1. HOLMAN: SIX DAY WINDOW BETWEEN FORMATION ANDGIFT SUFFICIENT DUE TO VOLATILE NATURE OF ASSET.. . . . . . 6

2. GROSS: ELEVEN DAYS SUFFICIENT TIME BETWEEN FORMATION AND GIFT TO AVOID INDIRECT GIFT ARGUMENT.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

3. LINTON: FORMATION AND GIFTS ON SAME DAY TREATEDAS AN INDIRECT GIFT. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

B. ANNUAL EXCLUSION TREATMENT FOR GIFTS OF INTERESTSIN LIMITED PARTNERSHIPS AND LIMITED LIABILITY COMPANIES. . . . 8

1. PRICE: GIFTS OF FLP INTERESTS FAILED TO QUALIFY AS A GIFT OF A PRESENT INTEREST.. . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

2. FISHER: GIFTS OF LLC INTEREST DID NOT QUALIFY FOR ANNUAL EXCLUSION TREATMENT. . . . . . . . . . . . . . . . . . . . . . . . . . 9

3. AVOIDING THE APPLICATION OF PRICE AND FISHER. . . . . . . . . . 9

Page #

III. GIFT TAX EXEMPTION IN 2010. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

IV. BENEFITS OF GIFT PLANNING DURING 2010. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

A. BENEFITS OF PAYING GIFT TAX DURING LIFE. . . . . . . . . . . . . . . . . . . . . 11

B. “NET” GIFTS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

V. ESTATE FREEZE PLANNING. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

A. SALE TO GRANTOR TRUSTS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

1. STRUCTURING A GRANTOR TRUST. . . . . . . . . . . . . . . . . . . . . . . . . 17

2. ADVANCED PLANNING WITH SALES TO GRANTOR TRUSTS.. . 18

B. GRANTOR RETAINED ANNUITY TRUSTS. . . . . . . . . . . . . . . . . . . . . . . . . . 22

1. GIFT TAX IMPLICATIONS.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

2. ZEROED OUT GRAT.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

3. IDEAL ASSETS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

4. RISK OF GRAT: DEATH OF GRANTOR DURING TERM OF GRAT.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

5. PENDING LEGISLATION AFFECTING GRATS. . . . . . . . . . . . . . . . . 24

C. PLANNING WITH 678 TRUSTS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

1. STRUCTURE OF A 678 TRUST. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

2. BUILDING VALUE IN THE 678 TRUST. . . . . . . . . . . . . . . . . . . . . . . . 26

3. RESULTS OF 678 TRUST PLANNING. . . . . . . . . . . . . . . . . . . . . . . . . 27

4. REPORTING REQUIREMENTS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

5. EXAMPLES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

Marvin E. Blum*•Gary V. Post*John R. Hunter"•Daniel H. McCarthy"•Steven W. Novak*Len Woodard•Catherine R. Moon*•Amanda L. Holliday*•Laurel Stephenson*Laura L. Bower-Haley*Amy E. Ott•Rachel W. SaltsmanKent H. McMahan,* Senior Counsel

The Blum Firm, P.C.Attorneys at Law

Fort Worth | Dallas

777 Main Street, Suite 700Fort Worth, Texas 76102

(817) 334-0066(817) 334-0078 (fax)

200 Crescent Court, Suite 520Dallas, Texas 75201

(214) 751-2130(214) 751-2160 (fax)

[email protected]

Board Certified by the Texas Board of Legal Specialization*Estate Planning & Probate Law "Tax Law

•Certified Public Accountant

ESTATE PLANNING: WHAT NEXT?Presented by Marvin E. Blum

Prepared by Marvin E. Blum & Amanda L. Holliday

“It was the best of times, it was the worst of times, it was the age of wisdom, it was the ageof foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light,it was the season of Darkness, it was the spring of hope, it was the winter of despair, we hadeverything before us, we had nothing before us, we were all going direct to heaven, we were allgoing direct the other way – in short, the period was so far like the present period, that some of itsnoisiest authorities insisted on its being received, for good or for evil, in the superlative degree ofcomparison only.” Charles Dickens, A Tale of Two Cities.1

Although Charles Dickens wrote these words over 150 years ago, they aptly describe thestatus of the estate tax laws today. When the Economic Growth and Tax Relief Reconciliation Act(“EGTRRA”) was passed in 2001, which provided that the estate tax would be repealed for one yearbeginning January 1, 2010, most practitioners believed that the Internal Revenue Code would beamended long before the estate tax repeal occurred. However, we are over halfway through 2010with no revision to the estate tax laws and no resolution in sight. As a result, under current law,individuals dying this year will pay no estate tax, but individuals dying in 2011 and later with assetsover $1 million will pay estate tax at a top rate of 55%. This situation is creating vast inequitiesbetween estates of decedents dying in 2010 and all other estates.

As a prime example of the unusual effect that EGTRRA has had, consider the story of DanL. Duncan. Duncan was a Texas pipeline tycoon who died in late March from a brain hemorrhageat the age of 77. Forbes Magazine estimated Duncan’s net worth at about $9 billion, ranking himthe 74th wealthiest person in the world. His holdings included boats, jewelry, automobiles,shotguns, a 5,500-acre wild game hunting ranch, and interests in EPCO and Dan Duncan L.L.P. IfDuncan had died in 2009, his estate would have owed approximately $4 billion in tax, and if he haddied in 2011, his estate would have owed almost $5 billion in tax (based on a $9 billion taxableestate). However, since Duncan’s death occurred in 2010, his estate will pay no estate tax.2

George Steinbrenner is another billionaire whose heirs will benefit from the one-year repeal.Steinbrenner, long-time owner of the New York Yankees, died at the age of 80 from a heart attackon July 13. Forbes Magazine estimated his wealth at $1.1 billion, which included his ownership inthe Yankees (and its related investments), various homes, and a stud farm in Ocala, Florida. By

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dying in 2010, Steinbrenner’s estate avoided between $495 million and $605 million in estate taxes.If all of Steinbrenner’s assets were sold, the income tax bill could be as high as $165 million, whichrepresents tax savings of about $330 million.3

As illustrated above, one way to avoid estate taxes is to die in 2010. If that doesn’t appealto you or your clients, however, the focus must be on planning now to reduce or eliminate estatetaxes at death. Dealing with the ever-changing landscape regarding planning for estate taxes hasbecome treacherous for individuals and their advisors. It is more important than ever to be awareof the latest developments affecting estate planning, as well as the best techniques to help clientsavoid estate taxes to the maximum extent possible. Below we have discussed the status of estate taxlegislation, as well as various techniques to help clients plan in the midst of this uncertainty.

I. 2010 COMPLIANCE: STATUS OF ESTATE TAX LEGISLATION

It is impossible to predict with certainty what actions Congress will take with regard to theestate tax during 2010, and even beyond. As of July 16, 2010, only one estate tax bill has beenintroduced in 2010. On June 24, 2010, Senator Bernard Sanders (I-VT) introduced the “ResponsibleEstate Tax Act,” with the support of Senators Tom Harkin (D-IA) and Sheldon Whitehouse (D-RI).

The proposed legislation calls for a $3.5 million estate tax exemption amount per person ($7million for couples). According to Senator Sanders, this would exempt 99.75% of all estates fromthe federal estate tax in 2011. The tax rate applicable to estates with a value between $3.5 millionand $10 million would be 45%. The tax rate applicable to estates with a value between $10 millionand $50 million would be 50%. The tax rate applicable to estates with a value greater than $50million would be 55%. With regard to any estate with a value above $500 million, the proposedlegislation would impose a 10% surtax on the portion of the estate that exceeds $500 million.

In addition, the proposed legislation would attempt to close estate and gift tax “loopholes”by requiring consistent valuations for transfer tax and income tax purposes, modifying rules applyingto valuation discounts, and requiring a 10-year minimum term for GRATs. The legislation wouldalso liberalize the Special Use Valuation rule with regard to farmland and the estate tax rules relatedto conservation easements.

Commentators have indicated that, if passed, the legislation would be retroactively effectiveas of January 1, 2010. As discussed above, very wealthy people have already died in 2010, whoseheirs have the wherewithal to challenge any such retroactive legislation on constitutional grounds.It is unknown whether such a challenge would be successful, and it would be many years before afinal resolution was reached if the law was challenged.

At this time, it is unknown how much support this bill has in Congress and whether it willgarner enough votes will pass. It is also possible that other legislation may be introduced later in theyear, and it remains to be seen what form such legislation will take.

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A. SUMMARY OF ESTATE AND GIFT TAX LAWS DURING 2010

Under current law, for estates of decedents dying in 2010, a modified carryover basis rulewill apply instead of an estate tax. Under Section 1022(a), the basis of property received from adecedent will be equal to the lesser of (i) the decedent’s adjusted basis in the property, and (ii) theproperty’s fair market value on the decedent’s date of death.

Section 1022(b) allows the basis of the property to be increased by up to $1.3 million forproperty passing to someone other than the decedent’s surviving spouse or a QTIP trust (i.e., abypass or credit shelter trust). The basis of property passing to the surviving spouse or to a QTIPtrust can be increased by up to $3 million. The surviving spouse’s one-half interest in communityproperty also qualifies to receive part of the $3 million basis allocation. In addition, capital losscarryovers and net operating loss carryovers that, but for the decedent’s death, would have beencarried forward to a later taxable year of the decedent and any losses that would have been allowableif the decedent had sold the property immediately before his or her death may be added to theproperty’s basis.

For example, assume an individual dies owning a batch of assets worth $5 million that havea basis of $2 million. The individual’s will leaves all of the assets to a QTIP trust for the survivingspouse. In that case, the assets will have a new basis of $5 million as of the individual’s date ofdeath.

Although no estate tax is applicable during 2010, the gift tax rules continue to apply totransfers made in 2010. The lifetime gift tax exemption continues to be $1 million per person, butthe gift tax rate for taxable gifts made during 2010 has decreased to 35%. The gift tax rulesapplicable during 2010 will be discussed in more detail later in this outline.

B. REVIEWING AND DRAFTING ESTATE PLANNING DOCUMENTS IN 2010

While waiting for Congress to act, we have been working with our clients to ensure that theirdocuments are in compliance with 2010 laws in the event that a client dies in 2010. We haveidentified several situations in which a client’s estate planning documents may require revising toensure that the documents do not have unintended consequences if a client passes away in 2010.Some examples of these situations are as follows:

• For married couples, a formula bequest where some of the assets pass to thesurviving spouse and the remaining assets pass to others, such as the children. Forexample, a will may use formulas to define a certain amount of assets that will passto a bypass trust for the children (i.e., an amount equal to the individual’s estate taxexemption) and provide that the remaining assets will pass to the QTIP trust. Whenapplying the 2010 laws to the formula to calculate the amount passing to the bypasstrust, the formula may be interpreted in such a way that all of the assets pass to thebypass trust or all of the assets pass to the QTIP trust.

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• A formula bequest where some of the assets pass to grandchildren and other assetspass to children. For example, the will might leave all of the individual’s GSTexempt assets to the grandchildren and the remaining assets to the children. Sincethere is no GST exemption in 2010, it is possible that no assets would pass to thegrandchildren if the individual died in 2010.

• Bequests that are defined by references to the estate tax exemption or GST exemptionamount. For example, a bequest that leaves an amount of assets equal to the estatetax exemption in effect at the individual’s death to children and the remaining assetsto charity. Since no estate tax exemption is applicable during 2010, the bequestcould arguably be read to leave all of the assets to charity, and none to theindividual’s children.

• Bequests that require the assets to qualify for a charitable contribution deduction ora marital deduction for estate tax purposes in order for the gift to be made. Forexample, a plan may make a bequest to charity but only allow it to be funded withassets that qualify for an estate tax charitable contribution deduction. There is noconcept of a charitable contribution deduction under 2010 laws, in which case the giftto the charity would arguably be zero.

The impact of 2010 laws on an estate plan depends on the way the particular document isdrafted. All documents are not the same, so it is important to read the documents carefully anddetermine the impact of the 2010 laws on a case-by-case basis. Amendments can often be made toa client’s plan to address any 2010 estate tax issues. Each situation is unique, so it is important todetermine the impact of such an amendment prior to it being implemented.

C. GENERATION-SKIPPING TRANSFER TAX ISSUES IN 2010

Another issue impacting decedents dying in 2010 and individuals making gifts in 2010 is thegeneration-skipping transfer (“GST”) tax. Under current law, the GST tax is not applicable totransfers made during 2010. Unless the statute is amended, transfers made to skip persons during2010 will not generate a GST tax. As a result, individuals can make gifts directly to skip personsduring 2010 without triggering GST taxes. Clients should also consider making distributions outof Nonexempt Trusts to skip persons since such distributions should not be subject to GST taxes in2010.

The one-year repeal of the GST tax also means that GST exemption may not be allocated togifts made to trusts during 2010. With regard to existing trusts that are currently GST exempt,making gifts to these types of trusts in 2010 may jeopardize the GST exempt status of the trusts.This is because the IRS could argue that a gift made in a year that no GST exemption could beallocated would cause the trust to only be partially GST exempt. Therefore, caution should beexercised before gifts are made to GST exempt trusts during 2010.

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With regard to life insurance trusts, or other trusts which might require annual gifts, oneoption is to make a loan to the trust in lieu of the gift. The donor can make a short-term (less thanthree years) loan to the trust and charge interest at the short-term applicable federal rate in effect onthe date of the loan. In January of 2011, when the GST exemption comes back into effect, the donorcan make a gift to the trust in an amount sufficient to allow the trust to pay off the balance of theloan, including interest. The donor can allocate GST exemption to the gift, ensuring that the trustremains GST exempt.

For new trusts, similar procedures can be followed. If a gift is made to a trust establishedduring 2010, the donor should consider making a late allocation of GST exemption effective January1, 2011. To do this, the donor would file a gift tax return reporting the late allocation, and an amountof GST exemption equal to the value of the trust assets on January 1, 2011 would be allocated to thetrust. As a result, the donor could ensure that the trust was GST exempt. In order to make a lateallocation of GST exemption, the gift tax return must be filed in the same month of the effective dateof the allocation.

D. SUNSET PROVISIONS AFFECTING 2010 LAWS

The statute currently states that the 2010 estate, gift, and GST tax laws are scheduled tosunset on December 31, 2010. As a result, on January 1, 2011, the law in effect prior to the passageof EGTRRA will spring back to life. Under those rules, the estate tax exemption will be $1 million,the highest estate tax rate will be 55%, and the GST exemption will be $1 million, indexed forinflation from 1997. Specifically, EGTRRA provides that the Act will not apply to decedents dying,gifts made, or GST transfers after December 31, 2010 and that the Code will be applied to decedentsdying, gifts made, and GST transfers occurring after December 31, 2010 as if EGTRRA had neverbeen enacted.

Some commentators have suggested that the language of the sunset provisions indicates that,in 2011 and later, the law will be applied as if EGTRRA never existed, even with respect to transfersmade before December 31, 2010. In other words, beginning on January 1, 2011, we would look backon transfers occurring prior to January 1, 2011 as if EGTRRA had never been enacted and pre-EGTRRA law was in effect at the time of the transfer. If the law is interpreted this way, it couldhave both positive and negative impacts. For gifts made in 2010, the law would apply as if the GSTtax existed during 2010 and could be allocated to gifts made during that year. This would helpalleviate some of the uncertainty related to gifts made to existing GST exempt trusts during 2010.

On the other hand, if the law is treated to have always existed as if EGTRRA had never beenpassed, then the automatic GST exemption allocations (which were part of EGTRRA) that we haverelied on for the past ten years would not be applicable, and as a result, many trusts might not befully GST exempt.

Note that under EGTRRA, in 2004, individuals had $1.5 million of GST exemption availableto allocate, which increased to $2 million in 2006, and to $3.5 million in 2009. With regard todecedents passing away in those years, trusts have been funded assuming a certain level of GSTexemption. For example, a decedent who died in 2006 may have created a GST exempt trust at his

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or her death, to which $2 million of GST exemption was allocated. Under pre-EGTRRA law, theGST exemption would have been a little over $1 million in 2006. If the IRS interprets the sunsetprovisions to mean that this trust should be examined as if EGTRRA never existed, then thetestamentary trust that was thought to be fully GST exempt might actually have an inclusion ratiobetween zero and one.

In addition, clients have made gifts to GST exempt trusts assuming a certain level of GSTexemption. A client may have made $2 million worth of gifts to a trust intended to be GST exemptover the past 10 years. Again, under pre-EGTRRA law, the GST exemption would not be largeenough to cover all of the gifts made to the trust, resulting in the trust having an inclusion ratiobetween zero and one if the IRS interprets the sunset provisions this way.

II. FAMILY LIMITED PARTNERSHIPS

Valuation discounts associated with interests in family limited partnerships (“FLPs”)continue to be an important component of estate planning. Discounts continue to be at historicallyhigh levels. FMV Opinions, a national valuation firm, (“FMV”) analyzed restricted stock andcontrol transactions during the Great Recession. Their analysis showed that discounts for lack ofmarketability and lack of control tend to increase when the Chicago Board Options Exchange’sVolatility Index (the “VIX”), which is a measure of volatility occurring on the S&P 500 Index,increases.

According to FMV, a VIX of 26.7 reflects discounts that are 5.1% higher than normal so thatif a typical discount for a private company during times of normal market risk is 35%, a VIX of 26.7would indicate a discount of 40%. The VIX reached a high of 48.2 in May of 2010, indicating thatvaluation discounts will be higher than normal for transfers made during that time. The VIXcontinues to be in the high 20’s, indicating higher than normal valuation discounts. Clients shouldtake advantage of these higher discounts by making transfers of FLP and LLC interests sooner ratherthan later. It is anticipated that, as the economy improves, the VIX will decrease, along withvaluation discounts.

Over the past year, some important cases have been decided that impact the way gifts ofinterests in FLPs should be structured. These cases highlight the importance of a sufficient amountof time passing between the formation and funding of the FLP and the date of the gift. In addition,the FLP must be structured so that the gift of the FLP interest will qualify as a present interest if thedonor intends for the gift to qualify for annual exclusion treatment.

A. INDIRECT GIFT ARGUMENTS FOR FLP AND LLC INTERESTS

1. HOLMAN: SIX DAY WINDOW BETWEEN FORMATION AND GIFTSUFFICIENT DUE TO VOLATILE NATURE OF ASSET

In Holman v. Commissioner, 130 T.C. No. 12 (2008), the Tax Court found that there was notan indirect gift where the gift of limited partnership interests was made six days after the partnership

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was formed. In that case, Mr. and Mrs. Holman formed a limited partnership and funded it with DellComputer Corp Stock in 1999. Six days later, they transferred 70.06% of their limited partnershipinterests to a trust for their children. Annual exclusion gifts were also made in 2000 and 2001 usingthe limited partnership interests. On their gift tax returns, Mr. and Mrs. Holman took a 49.25%discount when valuing the limited partnership interests.

The IRS argued that the transaction should be treated as an indirect gift of the Dell stock tothe trust and that the liquidation restrictions related to the limited partnership interests (and, thus, thevaluation discounts) should be disregarded under Section 2703. The Tax Court found that there wasno indirect gift that occurred because there was a real economic risk of a change in value betweenthe date of the partnership’s funding and the date of the gift due to the volatile nature of the Dellstock. It indicated that this would be a question of fact depending on the type of assets owned by thepartnership.

The Tax Court then turned to the Section 2703 analysis. Under Section 2703, an agreementwill be recognized for valuation purposes if (1) it is a bona fide business arrangement, (2) it is nota device to transfer property to family members for less than full and adequate consideration, and(3) its terms are comparable to similar arrangements arrived at in arms length transactions. Inanalyzing the first prong, the court found that the partnership did not qualify as a closely-heldbusiness because the only activity it carried on was holding Dell stock, which was not a business.Therefore, the Court found that the arrangement failed the first prong.

The Tax Court then analyzed the second prong by reviewing a specific provision of thepartnership agreement, which provided that if a partner made an impermissible transfer, the assigneeinterest would be redeemed at its fair market value, rather than for a price equal to the assignee’sshare of the partnership’s underlying property value. Since the redemption would occur at adiscount, it would benefit the remaining partners, all of whom were members of the Holman family.As a result, the Tax Court found that this provision indicated that the partnership was a device totransfer property to family members for less than full and adequate consideration, which violates thesecond prong.

Because the Court had found that the first and second prongs of the test were not met, it didnot render an opinion on the third prong and determined that the transfer restrictions should beignored for purposes of valuing the limited partnership interests in this case. The taxpayer appealedthe Court’s holding under Section 2703. The Eighth Circuit recently affirmed the Tax Court’sdecision in full (601 F.3d 763 (8th Cir. 2010)).

2. GROSS: ELEVEN DAYS SUFFICIENT TIME BETWEENFORMATION AND GIFT TO AVOID INDIRECT GIFT ARGUMENT

Gross v. Commissioner, T.C. Memo 2008-221, was another case in which the indirect giftargument was made by the IRS. Here, the partnership was funded with stock and bonds by thetaxpayer, and nominal amounts were also contributed to the partnership by her two daughters.Eleven days after the partnership was funded, the taxpayer gifted a 22.25% limited partnershipinterest to each of her daughters and applied a 35% discount when reporting the gifts on her gift tax

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return. Again, the Tax Court found that there was a real economic risk of change in the value of thepartnership between the date of funding and the date of the gift. The Tax Court also rejected theIRS’s step transaction argument.

3. LINTON: FORMATION AND GIFTS ON SAME DAY TREATED ASAN INDIRECT GIFT

Linton v. U.S., 104 AFTR 2d 2009-5176 (W.D. Wash.) involved a limited liability companythat was funded with cash, municipal bonds, and undeveloped real estate. On the same day that theassets were transferred to the limited liability company, gifts were made to the donor’s children.Based on these facts, the Court found that no valuation discount should be permitted with regard tothe limited liability company interests. Instead, the gift should be treated as a gift of the underlyingassets owned by the limited liability company. The Court noted that the limited liability company’sassets are not as volatile as those in the Holman and Gross cases. In addition, the Court determinedthat the step transaction would apply to negate valuation discounts in this case.

As these cases illustrate, it is important to let some time pass between the formation andfunding of the FLP and the transfer of the FLP interests. According to Steve Akers, a delay of 15days is probably safe, and others have thought that 30 days is appropriate. Of course, the morevolatile the FLP’s underlying assets, the shorter the delay that is needed.

B. ANNUAL EXCLUSION TREATMENT FOR GIFTS OF INTERESTS INLIMITED PARTNERSHIPS AND LIMITED LIABILITY COMPANIES

FLP interests are often used to make annual exclusion gifts. However, the FLP agreementmust be structured properly to ensure that gifts of FLP interests will qualify for annual exclusiontreatment.

1. PRICE: GIFTS OF FLP INTERESTS FAILED TO QUALIFY AS AGIFT OF A PRESENT INTEREST

In Price v. Commissioner, T.C. Memo 2010-2 (January 4, 2010), the Tax Court held that giftsof interests in an FLP did not qualify for annual exclusion treatment. In Price, the taxpayers – ahusband and wife – created an FLP and funded it with stock in the husband’s closely held companyand commercial property, which was leased to the company. The stock was subsequently sold andinvested in marketable securities.

In the years 1997 through 2002, the taxpayers made gifts of interests in the FLP to theirchildren, which were intended to qualify for annual exclusion treatment. The FLP agreementcontained the following restrictions:

i. The partners were prohibited from selling their FLP interests without thewritten consent of all of the other partners, although a limited partner waspermitted to sell his or her FLP interests to another partner without consent.

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ii. If a partner transferred his or her FLP interest, the other partners had anoption to purchase the FLP interest at its fair market value, determined inaccordance with the FLP agreement.

iii. The general partner had the discretion to make distributions (although amajority in interest of the partners could direct a distribution to be made). Inaddition, the FLP agreement stated that the distributions to partners weresecondary to the FLP’s purpose of achieving its investment objectives.

The IRS argued that, due to these restrictions, the gifts of FLP interests did not qualify forannual exclusion treatment because they did not constitute present interest gifts. The taxpayers’children could not freely transfer the FLP interests they received to anyone other than an existingpartner of the FLP. In addition, the taxpayers’ children had no right to income from the FLP interestsbecause they could not unilaterally require the FLP to make distributions of income to them.

Based on its analysis, the Tax Court determined that the taxpayers’ children did not have theright to presently use, possess, or enjoy the property and, therefore, the gifts did not qualify forannual exclusion treatment.

2. FISHER: GIFTS OF LLC INTERESTS DID NOT QUALIFY FORANNUAL EXCLUSION TREATMENT

In Fisher v. U.S., 105 AFTR 2d 2010-1347 (S.D. Ind.), the IRS argued that gifts of interestsin a limited liability company (“LLC”) should not qualify for annual exclusion treatment. The LLC’sprimary asset was undeveloped real estate that was used by the taxpayer’s family for recreationalpurposes. The LLC agreement provided that, if interests in the LLC were transferred to non-familymembers, the LLC had a right of first refusal for an amount equal to the price offered by theproposed transferee. If the right of first refusal was exercised, the LLC had 120 days to close, andthe payment could be made over a 15-year period. LLC interests could be transferred to familymembers without triggering the LLC’s right of first refusal, but even those transfers were subject tosome restrictions according to the court’s opinion.

The court found that these restrictions were sufficient to prevent the donees from transferringtheir LLC interests in exchange for immediate value. As a result, the annual exclusion treatment forthe gifts of the LLC interests was disallowed.

3. AVOIDING THE APPLICATION OF PRICE AND FISHER

There are a number of ways that taxpayers can attempt to avoid the application of the Priceand Fisher analyses to the taxpayer’s gifts of FLP and LLC interests. One option is to give therecipient of the FLP interest the right to sell the interest to anyone for a period of time, such as sixtyor ninety days. This would give the recipient the immediate ability to liquidate the FLP interest,allowing the recipient the ability to presently use and enjoy the property. Therefore, the gift shouldqualify as a present interest.

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A second option is to include a put right in the FLP agreement. A put right would allow therecipient to require the FLP to buy the recipient’s interest for a period of sixty or ninety days afterreceiving the FLP interest. The agreement could state that the purchase price of the FLP interestsubject to a put right would be the fair market value of the FLP interest, determined by taking intoaccount all applicable valuation discounts. The FLP agreement should also provide that the purchaseprice will be paid with cash or other liquid assets, in order to ensure that the donee will be treatedas having the right to presently use and enjoy the property.

A third option is for the donor to give a put right to the donee when the FLP interests aregifted (including the put right in the assignment document, rather than the FLP agreement). In thiscase, the donee would have the right to require the donor to purchase the donee’s FLP interest fora period of sixty or ninety days after the gift. As with the put right granted by the FLP, the put rightgranted by the donor should require the donor to pay the purchase price with cash or other liquidassets.

There is some question whether giving the donee a put right (whether in the FLP agreementor by the donor in the assignment document) would impact the value of the FLP interest for purposesof calculating the value of the gift, which centers on whether the existence of the put right wouldcause valuation discounts to be lower. However, since the annual exclusion amount is relativelysmall, it is unlikely that a reduced valuation discount would have a significant impact on the valueof the gift.

III. GIFT TAX EXEMPTION IN 2010

Although EGTRRA repealed the estate tax during 2010, it did not repeal the gift tax.Individuals continue to have a $1 million gift tax exemption, and gifts made in 2010 that exceed theexemption amount will be taxed at a rate of 35%. In 2009, the top gift tax rate was 45%.

While the gift tax exemption is typically referred to as an “exemption,” individuals actuallyhave a gift tax credit amount that is equal to the gift tax on $1 million worth of property gifted. Thecredit is calculated based on the tax rate in effect for the year during which the gift is made. As aresult, the reduced gift tax rate that applies to gifts made in 2010 will impact the amount of propertythat can be transferred as a gift in 2010 before the taxpayer will be required to pay gift taxes.

If an individual has made more than $500,000 in taxable gifts prior to 2010, the gift tax creditused in the past against prior gifts was based on a higher rate than the 35% rate that applies in 2010.As a result, the individual will not be able to make another $500,000 in gifts without paying gifttaxes.

For example, if an individual has gifted $600,000 worth of property prior to 2010, then hehas used $192,800 of his credit. During 2010, the gift tax credit is $330,800, so the individual willonly have $138,000 ($330,800 – $192,800) of his credit remaining in 2010. Based on a 35% gift taxrate, the gift tax credit of $138,000 represents a gift amount of $394,286 ($138,000 ÷ 35%). Thetotal amount that the individual can gift through 2010 without paying gift taxes will be $994,286($600,000 + $394,286).

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Alternatively, assume an individual made $950,000 worth of taxable gifts prior to January1, 2010. If the individual makes a taxable gift of $50,000 in 2010 (intending to “use up” his lifetimegift tax exemption), he would owe gift taxes of $12,700 [($326,000 credit used in prior years+$17,500 gift tax on $50,000 in 2010) – $330,800 gift tax credit amount for 2010].

A donor who has made taxable gifts before 2010 of about $961,000 will not be able to makeadditional gifts during 2010 without paying gift tax. While these amounts are relatively small, it isimportant to be aware of how the gift tax credit is computed so that a client is not unexpectedlyrequired to pay gift taxes.

This calculation can benefit clients who make large gifts in 2010. For example, a donor whohas made no taxable gifts prior to 2010 can make a $1 million gift in 2010 without paying gift taxes.The use of the gift tax credit will be computed based on the 35% tax rate in effect for 2010. Undercurrent law, the gift tax rate will increase for gifts made after December 31, 2010. Assuming amaximum rate of 45% in 2011 and later, the individual will be able to make an additional gift ofapproximately $36,000 in 2011 or later without paying gift taxes.

IV. BENEFITS OF GIFT PLANNING DURING 2010

The continued convergence of low interest rates, depressed asset values, and valuationdiscounts makes 2010 an ideal time to engage in gift planning. Coupled with these factors is the factthat the gift tax rate for taxable gifts made during 2010 is only 35%. In 2009, the maximum gift taxrate was 45%, and in 2011, the maximum gift tax rate will be 55%. This allows individuals totransfer more assets to future generations with less gift tax in 2010.

A. BENEFITS OF PAYING GIFT TAX DURING LIFE

It is mathematically better to pay gift tax during life than to pay estate tax at death. Whenthe gift tax is imposed, it is computed with regard to the value of the asset gifted. The donor thentransfers the asset to the beneficiary and pays the gift tax out of other assets. As a result, both theasset gifted and the cash used to pay the gift tax are outside of the donor’s estate (provided that thedonor lives three years after the date of the gift). Unlike gift tax dollars, estate tax dollars will bein the donor’s estate and will also be subject to estate taxes at the donor’s death. The gift tax is “taxexclusive,” whereas the estate tax is “tax inclusive.”

Not only is it better to transfer assets to pay gift taxes during life, but it is also important forclients to consider transferring assets that are subject to valuation discounts and have appreciationpotential. Because discounts are on the chopping block and asset values are at all-time lows, giftsshould be made sooner rather than later to take advantage of these circumstances.

Below are several examples of how making gifts and paying gift taxes during life canultimately affect the amount of assets passing to an individual’s heirs.

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Lifetime Gift of Discounted Asset. For example, assume an individual wants to transfer alimited partnership interest representing $5 million worth of underlying assets to his children.Assuming a 40% valuation discount, the partnership interest will be valued at $3,000,000 [$5 millionx (1 – 40%)]. If the individual gifts the partnership interest, the gift tax will be $1.05 million [$3million x 35% (based on a 35% tax rate and assuming the individual has no remaining lifetime gifttax exemption)]. As a result, a total of $4.05 million will be transferred out of the individual’sestate, $3 million of which will be transferred as a limited partnership interest that represents $5million of underlying assets to the children.

Hold the Asset until Death and Valuation Discount Applies. Instead, assume that theindividual dies owning $4.05 million – a $3 million partnership interest (representing $5 million ofunderlying property) and $1.05 million in cash. Assuming a 45% estate tax rate, the estate taxliability will be $1,822,500 ($4.05 million x 45%). After paying estate taxes, the estate will be leftwith $4,227,500 [$5 million (the undiscounted value of the partnership interest) + $1.05 million cash– $1,822,500] available to pass to the children. By holding the asset until death, $772,500 [$5million (the undiscounted value of the partnership interest) – $4,227,500] less will pass to theindividual’s children (when compared to making the gift during life). This example assumes thatvaluation discounts are still available when the individual dies.

Hold Asset until Death but No Valuation Discount Applies. However, if valuation discountsare not applicable at the decedent’s death, then the limited partnership interest would be valued at$5 million for estate tax purposes. As a result, the individual would own $6.05 million of assets forestate tax purposes – a $5 million undiscounted partnership interest and $1.05 million in cash.Assuming a 45% estate tax rate, the estate tax liability would be $2,722,500 ($6.05 million x 45%).After paying estate taxes, the estate will be left with $3,327,500 ($6.05 million – $2,722,500)available to pass to the children. By holding the asset until death and not having the benefit ofvaluation discounts, $1,672,500 [$5 million (the undiscounted value of the partnership interest) –$3,327,500] less will pass to the individual’s children (when compared to making the gift during lifewhile valuation discounts were applicable).

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Below is a summary of the above examples illustrating the impact that making gifts duringlife can have on the ultimate amount that will pass to the heirs:

Lifetime Gift ofDiscounted Asset

Hold Asset UntilDeath; ValuationDiscount Applies

Hold Asset UntilDeath; No

Valuation Discount

Assets Subject to Tax:

Discounted LP Interest $ 3,000,000 $ 3,000,000 -

Undiscounted LP Interest - - $ 5,000,000

Cash - 1,050,000 1,050,000

Total 3,000,000 4,050,000 6,050,000

Tax Rate 35% 45% 45%

Taxes Paid $ 1,050,000 $ 1,822,500 $ 2,722,500

Amount Passing to Heirs(undiscounted) $ 5,000,000 $ 4,227,500 $ 3,327,500

Appreciation that occurs with respect to the partnership interest during life is ignored in theabove examples. Any appreciation that the limited partnership enjoys during the individual’s lifewill serve to increase the amount of estate taxes paid at death and, thus, decrease the amount of theassets that ultimately pass to the children.

Some clients are hesitant to make taxable gifts during life, especially during 2010 when thepossibility exists that Congress could enact retroactive legislation to increase the gift tax rate above35%. To protect against the risk of retroactive legislation, but still take advantage of lower gift taxrates, a client can create an inter-vivos QTIP trust for the benefit of his or her spouse. The client willhave until April 15, 2011 to decide whether to make the QTIP election. If the gift tax rate remainsat 35%, the election would not be made and gift taxes would be paid based on that rate. If the gifttax rate is raised, the client can choose to make the QTIP election and forego paying gift taxes.

Because of the benefits of paying gift taxes during life, clients should consider makingtaxable gifts as part of their estate plan. In addition to transferring more assets to future generations,making taxable gifts during life allows the client to shift the appreciation on the gifted assets out ofhis or her taxable estate.

It is important to note that an individual must use up his or her lifetime gift tax exemptionbefore gift taxes will be paid. If the individual splits gifts with his or her spouse, then both theindividual and the individual’s spouse must use up their lifetime gift tax exemptions before gift taxeswill be paid.

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B. “NET” GIFTS

An alternative to the donor paying gift taxes is to make a “net” gift. Revenue Ruling 75-26permits the gift tax paid by the transferee to be deducted from the value of gifted property “whereit is expressly shown or implied that payment of tax by the donee or from the property itself is acondition of the transfer.” In a net gift, the transferor and the transferee enter into a net giftagreement, in which the transferee agrees to pay any gift tax resulting from the transfer, includingany additional gift tax resulting from an audit.

The transferee can be an individual or an irrevocable trust. It is important to considerwhether the transferee has sufficient liquid assets to pay the gift tax and structure the giftappropriately. If the transferee does not have sufficient liquid assets to pay the gift tax, the transferorcan make a loan to the transferee in an amount large enough to allow the transferee to pay the gifttaxes. The loan could be structured as a 9-year note with interest at the mid-term applicable federalrate, which is 2.35% for loans made during July of 2010.

The formula for calculating the net gift tax rate is: Tax Rate ÷ (1 + Tax Rate). For example,if the gift tax rate is 35%, the net gift tax rate will be 25.93% (0.35 ÷ 1.35). Assume an individualmakes a $2.7 million net gift to his children. The individual would transfer $2.7 million worth ofassets to his children and enter into a net gift agreement, where the children agree to pay the gifttaxes on the transfer. Based on a 35% gift tax rate, the net gift tax rate would be 25.93%. The gifttax paid by the children would be $700,000 ($2.7 million x 25.93%), leaving the children with$2,000,000 after paying gift taxes.

In the example above, a parent makes a $2.7 million net gift to his child, where the child pays$700,000 in gift taxes and nets $2 million. Alternatively, the parent can make a $2 million gift tohis child and pay $700,000 in gift taxes out of his own assets. In both examples, the parent’s estateis reduced by $2.7 million and the child’s estate is enriched by $2 million.

Making net gifts may appeal to individuals who have a psychological aversion to payingtaxes. By structuring the gift as a net gift, the donor does not have to write a check for the gift taxes.In addition, if the amount of the gift is increased by the IRS, the children will be required to pay theadditional gift taxes, rather than the donor. Net gifts may also appeal to individuals who do not havethe liquidity to pay gift taxes, but whose children or trusts benefitting the children have sufficientliquidity to cover the gift taxes.

V. ESTATE FREEZE PLANNING

Many gift and estate planning techniques exist that do not require the payment of gift taxes.These techniques generally focus on “freezing” the value of the client’s estate and shiftingappreciation on assets to future generations or trusts that will not be subject to estate taxes at theclient’s death. Some examples of estate freeze techniques include sales to grantor trusts, grantor-retained annuity trusts (“GRATs”), and 678 Trusts, which are discussed in more detail below.

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A. SALE TO GRANTOR TRUSTS

In a grantor trust structure, that the grantor will continue to personally pay the income taxeson the income generated by the trust’s assets, which allows the trust to grow without being depletedby income taxes. The grantor’s payment of these taxes is not treated as a gift to the trust. Studieshave shown that, in many cases, this single aspect of a grantor trust has an even greater impact onthe grantor’s ability to shift wealth to future generations than discounts. Therefore, as discounts arelimited or even eliminated, structuring irrevocable trusts as grantor trusts continues to be anextremely effective way of shifting significant wealth to future generations with minimal gift andestate tax cost.

In the sale to a grantor trust technique, the grantor creates a Trust and sells assets to it inexchange for a promissory note. The Trust generally has a longer time over which to pay off thepromissory note (typically up to 9 years). The steps involved in creating and implementing a grantortrust are as follows:

1. Grantor creates GST-exempt Grantor Trust for the benefit of the grantor’schildren and grandchildren. The grantor trusts could be structured as dynastytrusts. Not only do dynasty trusts help minimize estate taxes for futuregenerations, but they also protect the trust assets from beneficiaries’ creditors,spendthrift tendencies of beneficiaries, and spouses in the event abeneficiary’s divorce. The trustee of the trust controls the investment anddistribution of the trust assets. If a beneficiary’s access to trust assets needsto be minimized, the trust can be drafted with restrictions and a third partycan serve as trustee.

2. Grantor makes a seed gift to the Trust (or arrange for guaranties from thechildren or other trusts), typically in an amount equal to 10% or more of theentire transaction.

3. Assign LP units to the Trust (units of a limited partnership funded with someof the grantor’s investments).

4. Trust signs a promissory note payable to the grantor in an amount equal to thevalue of the assets sold to the Trust. The interest rate on the note would beequal to the mid-term AFR (which is 2.35% for July) for a 9-year note.

5. Obtain an appraisal of the LP units.

6. File a gift tax return reporting the sale to the Trust and allocate GSTexemption to the seed gift. This will begin the running of the 3-year statuteof limitations within which the IRS must audit the transaction.

7. As the Trust has liquidity, it makes note payments.

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Some risks associated with this technique include the risk of IRS challenge and whether thesale will be respected. In order to bolster the sale, it is important to ensure the trust has adequatecreditworthiness to support the sale. The grantor can do this by making a sufficient seed gift to thetrust in order to provide equity to support the sale. In addition, the trust beneficiaries or other trustscan serve as guarantors on the note owing back to the grantor and should receive a nominal guaranteefee for doing so (typically 3% of the amount guaranteed).

While the typical structure of the promissory note owing to the grantor is a 9-year termrequiring annual payments of interest, if the grantor has a shortened life expectancy, the promissorynote could be structured as a self-cancelling installment note (“SCIN”). In addition, the grantorshould consider hedging against a revaluation of the LP units by using McCord clauses, which arediscussed in more detail later in this outline.

Example:

Stock with a value of $1 million is transferred to a limited partnership (“LP”). TheLP units have a value of $700,000, assuming a 30% valuation discount. The LP units aresold to a Grantor Trust for a note in the amount of $700,000. The note requires annualpayments of interest at a rate of 2.35%, and a balloon principal payment at the end of 9 years.

The stock owned by the LP generates approximately $50,000 per year in dividends,all of which will be taxed on the grantor’s income tax return.

After 2 years, the assets owned by the LP have grown to $1.5 million. The Trust’sfinancial picture would be as follows:

LP units w/ underlying value of: $1,500,000Dividends ($50,000 x 2 years):* 100,000Note payable, principal balance: (700,000)Interest payment, year 1: ( 16,450)Interest payment, year 2: ( 16,450)Amount removed from estate: $ 867,100

Estate Tax savings (assuming 45% tax rate): $ 390,195

This kind of planning helps prefund the children’s inheritance. By setting aside assets forfuture generations now, the children and grandchildren do not have to wait until their parent orgrandparent dies to enjoy the assets. The amount set aside in this way is further compoundedthrough the use of grantor trusts because the grantor pays the income tax liability for the trust out ofhis or her own assets, as discussed above. As long as the grantor is amenable to paying the trust’sincome taxes, the trust will get a free ride on the income taxes and can grow without being depletedby them.

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If a family is charitably inclined, this type of planning can also allow the family to makesubstantial charitable gifts after the parents die, especially since the children will already havesubstantial wealth at that time. Many times, a client’s “optimal plan” may involve setting aside aportion of the estate for descendants and the remainder of th estate for charity. By funding theportion passing to descendants during life, the client can leave the assets remaining at his or herdeath directly to charity, thus eliminating estate taxes and the IRS as an “heir” of the estate. Thecharity that will receive the assets can be a private foundation created by the client during life or atdeath. Under this structure, the children receive two inheritances – one as a beneficiary of thegrantor trust for the children to spend and enjoy personally. The second is as a director of the familyfoundation where the child can help perpetuate the family’s name and charitable impact by doingpublic good.

1. STRUCTURING A GRANTOR TRUST

The following are some methods to design the Grantor Trust so that the grantor will betreated as the owner for income tax purposes:

a. Spouse as Beneficiary. If the Trust provides that the spouse is a permissiblebeneficiary of income and principal, then the Trust should be treated as a grantor trust in its entirety.Sections 677(a)(1) and (2).

b. Power of Grantor to Borrow from Trust. If the Trust provides that a grantorcan borrow from the Trust without providing adequate security for the loan, the Trust will be treatedas a grantor trust. Section 675(2).

c. Actual Loan from Trust to Grantor. If the Trust makes a loan to the grantoror the grantor’s spouse and the loan is not adequately collateralized, or in the case of a loan to thegrantor’s spouse, then loan does not require provide for adequate interest, the Trust will be treatedas a grantor trust. Section 675(3).

d. Payment of Insurance Premiums. If the principal and income of the Trust canbe used to pay life insurance premiums on the life of the grantor or his spouse, then the Trust shouldbe treated as a grantor trust. Section 677(a)(3). The IRS has gone back and forth on the issue ofwhether just the ability of the trustee to use trust income to make life insurance premium paymentson the life of the grantor is sufficient to cause the Trust to be treated as a grantor trust, or whetheractual use of the trust income to make such payments is necessary.

e. Substitution of Trust Assets. The ability of the grantor to substitute assets ofthe Trust for assets of equal value will cause the Trust to be treated as a grantor trust if such poweris exercisable in a non-fiduciary capacity without the approval or consent of someone in a fiduciarycapacity. Section 675(4)(C). The IRS has refused to rule on the question of whether a power canbe exercised in a non-fiduciary capacity on the grounds that it is a question of fact. PLRs 9437022,9524032, 9642039, and 9713017. However, in Revenue Ruling 2008-22, the IRS did conclude thata grantor’s retained power, exercisable in a non-fiduciary capacity, to acquire property held in a trust

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by substituting property of equivalent value will not, by itself, cause the value of the trust corpus tobe included in the grantor’s gross estate for federal estate tax purposes under either Section 2036 orSection 2038.

f. Power to Spray Principal and Income. If a majority of the trustees of the Trustare related or subordinate to the trustee and if the trustees have the ability to make discretionarydistributions of principal and income, then the Trust will be treated as a grantor trust. Section674(c).

g. Power to Add Beneficiaries. If a non-adverse party has the power to addbeneficiaries to the Trust, the Trust will be treated as grantor trust. Section 674.

2. ADVANCED PLANNING WITH SALES TO GRANTOR TRUSTS

i. McCord Clause and Its Effect on Undervaluation

If hard-to-value assets are sold to the Grantor Trust and the IRS successfully argues that theassets were worth more than the sales price, then the grantor may owe gift tax if the grantor has fullyutilized his or her lifetime gift tax exemption. One way to mitigate this risk is to use a McCordclause. A McCord clause can also be used to help further a client’s charitable goals.

The McCord clause is a valuation adjustment clause that is included in the saledocumentation that complies with the holding in McCord v. Commissioner, 461 F.3d 614 (5th Cir.2006). In McCord, the taxpayers, a husband and wife, sold all of their limited partnership interestsin a certain limited partnership to a GST exempt trust, their sons, and two charitable organizations.The taxpayers directed that a portion of the limited partnership interests equal in value to theirremaining GST exemption amounts pass to the GST exempt trust. Second, a portion of the limitedpartnership interests worth approximately $6.9 million, reduced by the amount passing to the GSTexempt trust, would pass to their sons. Third, a portion of the limited partnership interests worth$134,000 would pass to a charitable organization. Fourth, the limited partnership interests remainingafter funding the first three gifts would pass to a second charitable organization.

Subsequent to the transfer, an independent appraisal of the limited partnership interests wasobtained. Based on this appraisal, the GST exempt trust, the taxpayers’ sons, and the charitableorganizations entered into a confirmation agreement, in which they agreed on the exact percentageof limited partnership interests allocated to each of them. Under the transfer document, the limitedpartnership retained a “call” right with respect to the limited partnership interests transferred to thecharitable organizations. Approximately three months after the confirmation agreement was signed,the limited partnership exercised its call right and redeemed the charitable organizations’ interestsin exchange for cash.

The taxpayers filed a gift tax return reporting this transaction. When the gift tax return waslater audited, the IRS argued that the value of the limited partnership interests that actually passedto the GST exempt trust and the taxpayers’ sons (collectively, the “noncharitable assignees”) wasgreater than that which was reported on the gift tax return. The IRS’s argument was successful inthe Tax Court, which found in the IRS’s favor. The case was appealed to the 5th Circuit.

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The 5th Circuit ultimately held that the fair market value of the limited partnership interestsmust be determined as of the date of the gift and is not affected by subsequent events. Therefore,the confirmation agreement must be ignored and the IRS could not consider the exact percentage ofpartnership interests transferred to the noncharitable assignees. Rather, the IRS was bound by theformula clause, which directed that a portion of the limited partnership interests equal in value toapproximately $6.9 million pass to the noncharitable assignees. As a result, the taxable portion ofthe gift would not be greater than $6.9 million.

The McCord clause allows the client to give and/or sell a specific amount of property to thegrantor trust while, at the same time, transferring an amount to a charity of the client’s choosing.If the value of the property gifted and/or sold is later determined to be higher than the appraisedvalue, that additional value is also attributed to the charity. Thus, if the value of the property isredetermined by the IRS, the additional value transferred would qualify for the charitable gift taxexemption.

McCord clauses involve careful and intricate drafting, as well as specific procedures to makesure that the charity and the grantor trusts deal with each other at arm’s length. We have utilized theMcCord technique for several clients with appreciating assets who wanted to transfer a portion ofthe assets in a way that would benefit subsequent generations and one or more charitableorganizations. First, the clients form a grantor trust, naming their descendants as beneficiaries andgifted a nominal amount of cash to the trust. The clients then sell a portion of the asset to the trustand the remainder to a donor-advised fund.

The transfer document directs that an amount of the assets with a value equal to a certaindollar amount (assume $1 million for illustration purposes) will pass to the trust. The remainingamount of the assets will pass to the donor-advised fund. The trust executes a promissory notepromising to pay $1 million to the clients in exchange for its share of the assets. The portion passingto the donor-advised fund is treated as a charitable gift. A gift tax return should be filed allocatingGST exemption to the cash gift and reporting the above sale to the grantor trust.

The trust and the donor-advised fund subsequently agree on an allocation of the shares, basedon an appraisal that was performed by an independent appraisal firm. Over time, the trust repays thepromissory note. After the note is paid in full, the trust is left with the appreciation on the assets.By using this technique, clients can make these types transfers free of gift tax and using a minimalamount of their GST exemptions.

ii. McCord Clause Options

Option 1: Appraisal Obtained Prior to the Transfer

The Assigned Interest shall be allocated among the Assignees in the followingorder:

(a) that portion of the Assigned Shares having a fairmarket value as of the Effective Date equal to ___________________

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Dollars ($____________) is assigned to the Trustee of the IrrevocableTrust; and

(b) any remaining portion of the Assigned Interest isassigned to the Accepting Charity;

For purposes of this paragraph, the fair market value of the Assigned Sharesas of the Effective Date shall be the price at which the Assigned Interest wouldchange hands as of the Effective Date between a hypothetical willing buyer and ahypothetical willing seller, neither being under any compulsion to buy or sell andboth having reasonable knowledge of relevant facts for purposes of Chapter 12 of theInternal Revenue Code of 1986, as amended.

Option 2: Client Transferring a Specific Dollar Amount of Assets and Appraisal will be Obtainedafter Transfer

Note: In this example, the term “Assigned Interest” is defined earlier in the document as acertain dollar amount of assets (e.g., $50 million).

The Assigned Interest shall be allocated among the Assignees in the followingorder:

(a) that portion of the Assigned Interest having a FairMarket Value (as defined below) as of the Effective Date equal to$___________________ is assigned to the Trustee of the IrrevocableTrust; and

(b) any remaining portion of the Assigned Interest isassigned to the Accepting Charity.

For purposes of this Assignment Agreement, the “Fair Market Value” of anyasset is the price at which the asset would change hands between a willing buyer anda willing seller, neither being under compulsion to buy or sell and both havingknowledge of the relevant facts. Whenever the term “Appraised Value” is used inthis Agreement, it shall refer to the Fair Market Value as determined by the Appraiserand shall not be redetermined in the event that the actual Fair Market Value is laterdetermined to be different from the Appraised Value.

All parties to this Assignment Agreement acknowledge that valuation is adifficult discipline and the actual Fair Market Value of any asset may or may not beequal to the Appraised Value. Nevertheless, the portion of the Assigned Interest thatpasses to the Trustee of the Trust, shall be that portion of the Assigned Interest thathas an actual Fair Market Value equal to $_____________________. This formulacould result in the Accepting Charity ultimately receiving substantially less than ormore than $_____________ if it is later determined that the Appraised Value isinaccurate.

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Option 3: Client Transferring All of His or Her Interest in a Specific Asset (i.e., a LimitedPartnership Interest or a Certain Number of Shares of Stock) and Appraisal will be Obtained afterthe Transfer

The Assigned Interests shall be allocated among the Assignees in thefollowing order:

(a) that portion of the Assigned Interests having an actualFair Market Value as of the Effective Date equal to the differencebetween (i) the Appraised Value and (ii) Five Hundred ThousandDollars ($500,000.00) is assigned to the Trustee of the IrrevocableTrust; and

(b) any remaining portion of the Assigned Interests isassigned to the Accepting Charity.

For purposes of this Assignment Agreement, the “Fair Market Value” of theAssigned Interests as of the Effective Date shall be the price at which the AssignedInterests would change hands as of the Effective Date between a hypothetical willingbuyer and a hypothetical willing seller, neither being under any compulsion to buyor sell and both having reasonable knowledge of relevant facts for purposes ofChapter 12 of the Internal Revenue Code of 1986, as amended.

All parties to this Assignment Agreement acknowledge that the actual FairMarket Value of the Assigned Interests may or may not be equal to the AppraisedValue. Nevertheless, the portion of the Assigned Interests that pass to the Trustee ofthe Irrevocable Trust, shall be that portion of the Assigned Interests that has an actualFair Market Value equal to the Appraised Value, less Five Hundred ThousandDollars ($500,000.00). This formula could result in the Accepting Charity ultimatelyreceiving substantially less than or more than Five Hundred Thousand Dollars($500,000.00) if it is later determined that the Appraised Value is inaccurate.

iii. Self-Cancelling Installment Notes

Using a self-cancelling installment note (“SCIN”) may be appropriate where the client isconcerned whether he will outlive the term of the note to the grantor trust. A SCIN is a debtobligation which will terminate upon the seller’s (grantor’s) death, with any remaining balancepayable by the purchaser (trust) automatically cancelling, potentially saving millions of dollars inestate taxes. In order to compensate the seller for the risk of cancellation, the SCIN must have a riskpremium, which can be in the form of a higher interest rate or a higher sales price. With today’sextremely low applicable federal rates, the SCIN premium is not nearly the deterrent that it is in ahigher interest rate environment.

There should be no gift upon the sale of the assets in exchange for the SCIN provided thatthe interest rate or principal is adjusted to compensate the seller for the self-cancelling feature.

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NumberCrunchers is an estate planning/financial planning software that performs the calculationsas to what an appropriate interest rate or principal premium should be.

For example, assume a client who is 60 years old sells an asset worth $1 million to a grantortrust in exchange for a SCIN with a 9-year term. Based on a 2.8% Section 7520 rate and a 2.35%mid-term AFR (both effective for transactions occurring in July 2010), and assuming that the SCINwould be self-amortizing, the principal risk premium would be $80,485, resulting in the SCINhaving a principal amount of $1,080,485 and an interest rate of 2.35%. The interest risk premiumwould be 1.6669%, resulting in the SCIN having a principal amount of $1,000,000 and an interestrate of 4.0169%.

The SCIN can be structured many different ways, depending on a client’s specific situation.The note can be self-amortizing, require level principal payments, or require payments of interestonly with a balloon payment of principal at the end of the note term. Each structure will require adifferent principal or interest risk premium and should be analyzed carefully before the final structureis chosen.

Since the note cancels upon the death of the seller, the note has no value for purposes ofcomputing the seller’s gross estate. The use of a SCIN was recognized as a bona fide sale by theSixth Circuit in Costanza v. Commissioner, 320 F.3d 595 (6th Cir. 2003), rev’g TCM 2001-128.The Sixth Circuit Court of Appeals held that a sale utilizing a SCIN was a bona fide sale of property;however, the Sixth Circuit remanded the case back to the Tax Court to determine if any portion ofthe SCIN was a “bargain sale” and therefore partially a taxable gift.

B. GRANTOR RETAINED ANNUITY TRUSTS

A grantor retained annuity trust (“GRAT”) is a trust designed to comply with therequirements of Section 2702 of the Code. Section 2702 provides that for purposes of determiningwhether or not a transfer in trust for the benefit of one or more members of the grantor’s family isa gift, the value of the interest retained by the grantor will be valued at zero unless the interest is aqualified interest.

1. Payments to the grantor must be made at least annually. § 2702(b)(1).

2. The payments must be either a fixed amount (annuity) or a fixed percentage of thefair market value of the assets transferred to the GRAT at the date of transfer(unitrust). Treas. Reg. § 25.2702-3(b)(1)(ii).

3. Payments from one year to the next may not increase by more than 20%. Treas. Reg.§ 25.2702-3(e), Example 2.

4. The trust agreement must prohibit additional contributions from being made to thetrust. Treas. Reg. § 25.2702-3(b)(4).

5. The trust agreement must prohibit commutation of the interest of the grantor.

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1. GIFT TAX IMPLICATIONS

Assuming that the Section 2702 requirements are satisfied, then the annuity or unitrustinterest retained by the grantor will be a qualified income interest. The value of the remainderinterest will be treated as a taxable gift from the grantor to the remainder beneficiaries of the GRAT.The amount of the taxable gift is affected by the following factors:

• Term of the GRAT. The longer the term of the GRAT, the lower the value of theremainder interest.

• Section 7520 Rate. The higher the §7520 rate, the higher the value of the remainderinterest. Therefore, lower §7520 rates generate lower gift tax costs.

• Annuity or Unitrust Amount. The higher the annuity or unitrust amount paid to thegrantor each year, the lower the value of the remainder interest.

2. ZEROED OUT GRAT

The Tax Court decision in Walton v. Commissioner, 115 TC 589 (2000), now effectivelyallows a taxpayer to “zero-out” a GRAT – meaning that the remainder interest would be valued atzero or slightly in excess of zero depending upon the manipulation of the factors discussed in Section1 above. Obviously, the grantor cannot adjust the Section 7520 rate, so the grantor will have tomanipulate the term of the GRAT and the payout amount in order to effectively zero out the GRAT.

3. IDEAL ASSETS

The ideal assets to be used for a GRAT are those with significant appreciation potential.

• Single Stock. Particularly effective is the creation of a GRAT with a single stock,since a diversified portfolio will likely not have the significant appreciation potentialof a single stock. Since a GRAT can be designed to zero out the value of theremainder interest, the grantor will not “waste” lifetime gift tax exemption byallocating to a transfer in which the assets decline in value or fail to grow at a rate inexcess of the § 7520 rate. Thus, a grantor could create a series of zeroed out GRATswhich are each funded with a single stock. The GRATs in which the stockappreciates in excess of the § 7520 rate will have achieved the goal of transferringvalue from the grantor’s estate with little or no transfer tax cost. From a transfer taxperspective, the grantor will not suffer because of the GRATs which have stockswhich decline in value or fail to grow in excess of the § 7520 rate. The grantor’sonly loss will be the professional fees associated with the creation of the GRAT.

• Grant of Option to Acquire Stock. One idea is for the grantor to transfer an optionto acquire stock which the grantor owns to a GRAT. The option should be writtenso that there can be a cash settlement upon exercise of the option. If the underlyingstock increases in value, then the trustee of the GRAT will choose to exercise theoption.

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• Substitution of Low Basis Assets. If a grantor has established a GRAT with lowbasis assets, the grantor can retain the right in the GRAT to substitute assets of equalvalue. Thus, a grantor can transfer cash or other high basis assets to a GRAT beforethe expiration of the term so that the low basis assets might be included in thegrantor’s taxable estate which will provide for a basis step up at the grantor’s death.

4. RISK OF GRAT: DEATH OF GRANTOR DURING TERM OF GRAT

If the Grantor dies during the term of the GRAT, then either the fair market value of theassets in the trust will be included in the Grantor’s taxable estate under Section 2036, or possibly thevalue of the assets in the GRAT necessary to produce sufficient income under Section 2039.

5. PENDING LEGISLATION AFFECTING GRATS

Many different bills this legislative session have included provisions requiring a 10-yearminimum term for GRATs, among other things. The most recent bill was passed by the House onJuly 1, 2010. H.R. 4899 is a supplemental spending bill which included the following provisionsaffecting GRATs:

• GRATs must have a term of not less than 10 years.

• The annuity payments, when determined on an annual basis, may notdecrease relative to any prior year during the first 10 years of the GRAT’sterm.

• The remainder interests must have a value greater than zero as of the time ofthe transfer to the GRAT. Theoretically, a remainder interest of $1 should besufficient.

Under the terms of H.R. 4899, these provisions will apply to transfers made after the date ofthe bill’s enactment. The bill will be taken up by the Senate next. According to commentators,members of the Senate have strongly indicated that they would like to save provisions affectingGRATs (which will serve as revenue raisers) to offset the cost of future estate tax legislation (e.g.,to offset lost revenue if a bill increases the estate tax exemption above $1 million). It is possible thatGRAT legislation will not be passed soon, but most believe that it is just a matter of time beforelegislation like this will become law. Note that the Responsible Estate Tax Action discussed abovemay also have implications on how GRATs can be structured.

As a result, we are continuing to encourage our clients to take advantage of short-termGRATs while this technique is available. There may still be time to use this technique to transferwealth to future generations with little or no gift tax cost, but the window of opportunity appears tobe closing.

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C. PLANNING WITH 678 TRUSTS

Typically, when a client is considering options to help reduce estate taxes, the client mustconsider techniques that require the client to part with at least a portion of the assets he or she hasaccumulated over the years, as well as part with future appreciation. For example, many estateplanning techniques involve gifting and/or selling the client’s assets to trusts that benefit the client’schildren. In these situations, it can be difficult to balance the client’s desire to reduce estate taxeswith the client’s need to retain sufficient assets to maintain his or her standard of living.

One vehicle that allows the client to combine asset protection, estate tax savings associatedwith “estate freeze” techniques, and the continued ability to benefit from assets he or she hasaccumulated over the years is the “678 Trust.” The 678 Trust is named after the Internal RevenueCode Section upon which it is based, which states that a beneficiary who has a withdrawal rightunder a Crummey trust will be treated as the owner, for income tax purposes, of the portion of thetrust over which the withdrawal power lapsed.

1. STRUCTURE OF A 678 TRUST

The 678 Trust is established by the client’s parents, sibling, or close friend with a gift of$5,000. The client is the primary beneficiary and can receive distributions for health, education,maintenance, and support purposes. The client can also be named as the trustee. The Trust isstructured initially as a “non-grantor” or “complex” trust for income tax purposes. Therefore, the678 Trust is initially a separate taxpayer for income tax purposes. However, the 678 Trust alsoincludes a “Crummey” withdrawal right for the client. If the client refuses to withdraw the initial$5,000 contribution, the 678 Trust becomes a grantor trust as to the client. Thus, all income taxeffects of the 678 Trust from that point forward become the responsibility of the client.

As a result, the client can sell assets to the 678 Trust without being required to recognize gainon the sale. In addition, if the client sells assets to the 678 Trust in exchange for a promissory noteor loans money to the 678 Trust, the client will not be required to recognize the interest paymentsas income. This characteristic also causes the 678 Trust to be a permissible owner of S corporationstock, without requiring the Trust to elect to become a qualified subchapter S trust (“QSST”) or anelecting small business trust (“ESBT”).

Furthermore, the client will be responsible for paying the income tax on the income generatedby the Trust’s assets. Assets outside of the Trust can be used to pay the income taxes, allowing theTrust assets to grow without being depleted by income taxes. This also allows the client to “spenddown” assets that would otherwise be includable in his or her estate and subject to estate taxes atdeath. If the time came that the client were unable to pay the income taxes out of his or her ownassets, the 678 Trust could make a distribution to the client in the amount of the income taxes underthe health, education, maintenance, and support standard.

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2. BUILDING VALUE IN THE 678 TRUST

The 678 Trust can be utilized by almost any type of client. The most obvious use of a 678Trust is for clients who are expecting to purchase an asset that has high appreciation potential, arestarting a business, or are expanding an existing business (but as discussed below, it can also be usedfor existing assets with appreciation potential or that are subject to valuation discounts). Someexamples include buying a new business opportunity, engaging in additional drilling operations, orinvesting in restaurant franchises.

In those cases, the client can make a loan to the 678 Trust to enable it to buy the asset, startthe new business, or expand the existing business. In order for the loan to be respected by the IRS,it must carry an interest rate equal to, at a minimum, the applicable federal rate for the type andlength of the loan. As the asset or business grows in value, the loan can be repaid. The asset willcontinue to be owned by the 678 Trust, where it will not be subject to estate tax at the client’s death.Once the 678 Trust has built up significant assets, it can simply purchase new assets using its owncredit.

The 678 Trust can also be useful for clients who have existing assets that have appreciationpotential or that are valued at a discount. In these cases, it might be desirable for the client to sellthe asset to the 678 Trust in exchange for a promissory note. For the reasons discussed below, it isimportant that the sale be structured so that it will be respected by the IRS as a bona fide sale underSection 2036 of the Code. The 678 Trust needs to have sufficient substance to support the sale,which can be problematic if the Trust is new and has not yet built up significant value.

To remedy this situation, the 678 Trust can have other trusts or individuals (other than theclient) guarantee the note owing to the client. If no other trusts or individuals are available toguarantee the note, the client can create a separate trust for his or her children and make a $1 milliongift (or $2 million if the client is married and gift splits with his or her spouse) to it. The new trustcan then provide a guarantee to the 678 Trust in exchange for a guarantee fee. To supercharge thenew trust, it can be structured as a grantor trust with respect to the client for income tax purposes andas a GST exempt dynasty trust.

It is important when the client transacts with the 678 Trust that the transaction be structuredat fair market value, and that no gifts be made to the 678 Trust beyond the $5,000 contributedby the client’s parents. Any additional gifts could alter the income tax and estate tax characteristicsof the 678 Trust. Furthermore, if the client is treated as having made a gift to the 678 Trust, then theTrust’s assets will be subject to estate taxes when the client dies.

In order to guard against the client being treated as having made a gift to the 678 Trust whenhe or she loans money to the Trust, the interest rate on the loan should be at least equal to theapplicable federal rate in effect at the time the loan is made. When assets are sold to the Trust, thesales price must be equal to the fair market value of the asset. Sale documents can includeadjustment clauses, where the 678 Trust and the client agree that, if the fair market value of the assetsold to the Trust is ever determined to be different than that agreed upon by the Trust and the client,

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the sales price will be adjusted to reflect the differently determined fair market value. This will helpavoid the argument that the client made a gift to the 678 Trust if the sales price is determined to belower than the asset’s fair market value.

The 678 Trust can also allow the client to exercise a special power of appointment (“SPOA”)over the Trust assets. By possessing an SPOA with respect to the Trust assets, any inadvertent giftthat the client may have made to the Trust will be treated as an incomplete gift. Treasury Regulation§ 25.2511-2(b) provides that, if a donor transfers property (to a trust or otherwise) but retains thepower to control how the property will be disposed of, then the gift by the donor will be incomplete.The SPOA gives the client-beneficiary the power to control how the property will be disposed of athis or her death. As a result, if the client is treated as having made a gift to the 678 Trust, the giftwill be incomplete from a gift tax perspective and no gift tax will be due at that time.

Although the gift will be incomplete for gift tax purposes, the gift will cause all of the Trustassets to be included in the client’s estate at death because the client will have made a gift to a trustof which he is a beneficiary. As a result, the tax will not be avoided by virtue of the gift beingtreated as incomplete, it will merely be postponed until the client’s death.

The SPOA also gives the client the flexibility to modify the terms of the Trust on his or herdeath to account for changed circumstances. The SPOA can be so broad as to allow the client toexercise it in favor of anyone (including other individuals, trusts, and charitable organizations) otherthan the client, the client’s estate, the client’s creditors, or the creditors of the client’s estate.

3. RESULTS OF 678 TRUST PLANNING

The 678 Trust should be structured as a GST exempt dynasty trust. When the initial gift ismade to the 678 Trust, the client’s parents should allocate GST exemption to the Trust, which willallow it to pass to future generations free of transfer taxes. As a result, the assets owned by the Trustshould not be subject to estate tax at the death of the client or the client’s parents. In addition, the678 Trust should contain a spendthrift provision, in which case the Trust assets should be protectedfrom the client’s creditors.

With regard to assets sold to the 678 Trust, the value of the assets owned by the client arefrozen at the value of the note the client received in the sale. The client can spend down these assetsby paying the income tax liability generated by the Trust’s assets and allow the assets owned by the678 Trust to grow without being depleted by income taxes.

The Trustee of the 678 Trust has the ability to distribute Trust assets to the client and his orher issue for health, education, maintenance, and support needs, and the client may be given a limitedinter vivos or testamentary power of appointment over the assets of the 678 Trust to account forchanges in family circumstances or the law. Upon the client’s death, the 678 Trust can be draftedto divide into separate trusts for his or her children, and those trusts will be considered “complex”trusts for income tax purposes.

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4. REPORTING REQUIREMENTS

The creator of the 678 Trust should file a gift tax return reporting the $5,000 gift to the Trustand allocating GST exemption to the gift. The gift tax return will be due on April 15 of the yearfollowing the year in which the $5,000 gift is made.

When the client transacts with the 678 Trust, he or she should file a gift tax return disclosingthe sale or loan in order to start the running of the 3-year statute of limitations. Assuming that thedisclosure is adequate, if the IRS does not audit the gift tax return within the 3-year period, they willbe prohibited from challenging the transaction later on. The gift tax return will be due on April 15of the year following the year in which the transaction takes place.

5. EXAMPLES

Example #1: The example below illustrates how the 678 Trust would be structured when theTrust will be investing in a new business, expanding an existing business, or purchasing a new assetfrom a third party.

Step 1: Client decides to buy a new business, and the purchase price is $100,000.

Step 2: Parents of client (“Mom and Dad”) create a non-grantor trust (the “Trust”) forthe benefit of the client (“Son”) and his descendants. Mom and Dad initiallyfund the Trust with $5,000, and the Trust provides that Son has a Crummeywithdrawal right over contributions to the Trust.

Step 3: Son receives notice of withdrawal right and allows the withdrawal right tolapse.

Step 4: Trust creates a limited liability company (“LLC”) to purchase the newbusiness. Trust is the sole member of the LLC. [Note: If expanding anexiting business (such as acquiring more product lines or franchises,additional oil and gas drilling, etc.), the new activity will be owned by thenew LLC rather than the existing business.]

Step 5: Trust borrows $100,000 from a bank or a third party. Son, Son’s existingbusiness, or another trust guarantees the Trust’s debt to the bank/third partyfor a small fee. Alternatively, the Trust can borrow $100,000 from Sondirectly, with interest on the loan charged at the applicable federal rate.

Step 6: Trust contributes $100,000 to LLC. LLC purchases new business opportunityfor $100,000.

Step 7: Mom and Dad file Form 709 Gift Tax Return, reporting a $5,000 gift to Trustand allocating $5,000 of GST exemption to the Trust, making the Trust fullyexempt from GST tax.

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Step 8: Son manages and grows new business. All of the income from the Trustassets is taxed to Son. If necessary, Son (or his descendants) may receivedistributions of Trust income or principal.

Step 9: Trust continues to own and operate business, and has sufficient capital toacquire new business opportunities or other assets. Son and his children canbenefit from Trust income or principal. The assets are protected fromcreditors. At Son’s death, if Trust assets are worth $5 million, then Son hassaved approximately $2 million in estate tax.

Example #2: The example below illustrates how a 678 Trust transaction would be structuredwhen the 678 Trust plans to purchase an existing business or other asset from the client. This useof the 678 Trust may be a fit for more clients’ situations.

Step 1: Client owns a package of investment assets that have high appreciationpotential. The package of investment assets is currently worth $15 million.

Step 2: Client contributes the investment assets to a limited partnership (the “LP”).Assuming a 40% valuation discount, the LP interests would be worth $9million.

Step 3: Client creates a grantor trust for the benefit of client’s children (the “GrantorTrust”) and makes a gift of up to $1 million worth of LP interests to it. IfClient is married, Client’s spouse can also make a gift of up to $1 millionworth of LP interests to the Grantor Trust. (Note: This step is not necessaryif the client has already created trusts for his children that have substantialvalue.)

Step 4: Parents of client (“Mom and Dad”) create a non-grantor trust (the “678Trust”) for the benefit of Client and his descendants. Mom and Dad initiallyfund the Trust with $5,000, and the Trust provides that Client has a Crummeywithdrawal right over contributions to the Trust.

Step 5: Client receives notice of withdrawal right and allows the withdrawal right tolapse.

Step 6: 678 Trust purchases Client’s LP interests in exchange for a promissory note.The note is structured as a 9-year note, with interest at the mid-termapplicable federal rate. New Grantor Trust (or previously existing trust, ifsuch exists) guarantees at least 10% of the note amount in exchange for asmall fee.

Step 7: An appraisal of the LP interests is obtained for the purpose of determining theexact percentage transferred to the Grantor Trust and determining theprincipal amount of the promissory note owing by the 678 Trust.

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1. We must give credit to Stanley Johanson for this astute reference to Charles Dickens. Professor Johanson opened his presentation, Recent Developments Affecting Estate Planning, atthe Fort Worth Business & Estate Council Meeting on March 25, 2010 with this quote.

2. David Kocieniewski, Texas Billionaire’s Legacy: Death, but No Taxes, N.Y. TIMES, June 9,2010, at A1.

3. Associated Press, Steinbrenner Heirs May Save Millions on the Estate Tax, N.Y. TIMES, July14, 2010.

Step 8: Mom and Dad file Form 709 Gift Tax Return, reporting a $5,000 gift to Trustand allocating $5,000 of GST exemption to the Trust, making the Trust fullyexempt from GST tax.

Step 9: Client files a Form 709 Gift Tax Return, reporting the $1 million gift to theGrantor Trust and reporting the sale to the 678 Trust. A copy of the appraisalshould be attached to the Return.

Step 10: All of the income from the Grantor Trust assets and the 678 Trust assets istaxed to Client. If necessary, Client (or his descendants) may receivedistributions of income or principal from the 678 Trust. Client’s descendantsmay also receive distributions of income or principal from the Grantor Trust.The assets owned by the 678 Trust and the Grantor Trust are protected fromcreditors.

Step 11: Trust continues to own the LP, which owns and manages the investmentassets. Over time, the investment assets appreciation. At Client’s death, ifTrust assets are worth $25 million, then Client has saved approximately $7.2million in estate tax. [Calculated as follows: (i) $25 million less $9 million(the $1 million gifted, which used up lifetime gift tax exemption, plus the $8million sold, in exchange for which Client received a promissory note thatwas repaid over time), multiplied by (ii) 45% tax rate.]

The 678 Trust technique helps reduce estate taxes, provides creditor protection, and givesthe client the ability to continue to benefit from the assets during his or her life. When compared toother estate planning techniques, such as GRATs (discussed above), the 678 Trust is superiorbecause, among other things, (i) the client does not have to survive the transaction with the 678 Trustby any period of time in order for the assets to be outside of the client’s estate, and (ii) the estate taxinclusion period rules do not apply, so that GST exemption can be allocated to the Trust on itscreation. The 678 Trust can be structured and customized to fit many different situations.

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